The Pound-to-Euro Rate: Bet on a rise to 1.20 say Strategists

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Strategists are betting on further gains for the Pound against the Euro following the pro-Sterling message delivered by the Bank of England at their February monetary policy event, but the path higher will not be smooth owing to tumultuous Brexit negotiations.

Pound Sterling is set to rise sharply against the Euro over the coming months as markets are forced to price in a faster pace of interest rate rises from the Bank of England while the Euro pauses its ascent for a breather.

Some strategists are betting that this will see Sterling moving back to its highest level seen against the Euro since the Brexit referendum of 2016 while others, still bullish, are calling for a milder pace of gains.

The subsequent series of trades, upgrades to interest rate forecasts and foreign exchange price targets comes after the Bank of England prompted a rise in the value of Sterling after saying Thursday that it may raise interest rates faster than it had previously led markets to believe.

"The Committee judges that, were the economy to evolve broadly in line with the February Inflation Report projections, monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent over the forecast period than anticipated at the time of the November Report,” says a note from the Bank relaying the minutes of their February policy meeting.

Following the surprise news that UK interest rates will need to rise faster than previously anticipated, the Pound-to-Euro exchange rate jumped to a high at 1.1449 having been as low as 1.13 earlier in the day before paring gains and closing the day at 1.1364.

BoE rate-setters have turned hawkish after the latest round of inflation forecasts from the bank showed the consumer price index remaining above the 2% target for as long as the Bank can forecast.

“With the Bank of England adopting a more hawkish posture at this MPC, we expect markets to converge to our expectation of a rate hike in May,” says Ned Rumpeltin, European head of FX strategy at TD Securities.

Indeed, since the Bank’s statement Thursday, many economists and strategists are predicting two and, in one case, three interest rate hikes this year.

Pricing in interest rate derivatives markets, which enable investors to protect themselves against changes in interest rates, currently assigns a 70% probability of a rate hike in May having been down at 50% ahead of the Bank of England event.

“With the USD in the midst of a broader correction, we favour EUR/GBP over cable to express a more positive near-term outlook for sterling, particularly as EUR hard data surprises may have peaked,” adds Rumpeltin.

Raising interest rates is the Bank of England’s best possible remedy for higher prices. A side effect of higher interest rates is a stronger currency, hence the rise in Sterling and renewed optimism about what might come next.

In fact, any change of the derivative and bond market implied probabilities of more rate hikes would be enough to deliver a powerful boost to Sterling.

“Investors looking for tactical opportunities may see greater value in EUR/GBP downside - given the looming Italian elections and prospect of some more cautious ECB currency talk. We're looking for a move to 0.86 in 1Q18,” says Viraj Patel, a foreign exchange strategist at ING Group, referring to a level of EUR/GBP that translates into a Pound-to-Euro rate of 1.1627.

The Pound-to-Euro rate rose back above the 1.1400 level Thursday but Patel has argued that for the Pound to rise meaningfully from current levels, a transitional Brexit agreement will need to be reached before the European Council summit on March 22.

The FX strategy team at TD Securities are nevertheless of the opinion that now could be the time to enter a trade to benefit from a rise in the value of the Pound and they have entered a trade in their model portfolio that will pay out if the Pound-to-Euro rate reaches 1.1976.

“We are adding a short EUR/GBP position to our FX model portfolio. We open this position on a spot reference of 0.8750. Our initial target is a move down to 0.8350 with a stop at 0.9025,” TD Securities’s Rumpeltin wrote in a note Thursday.

The expected horizon of the trade is three months.

For those looking at the market from a GBP/EUR angle, 0.8750 in EUR/GBP gives us 1.1428, 0.8350 gives us 1.1976 and 0.9025 gives us 1.1080.

There are risks to the trade though: "ongoing UK political tensions present the clearest risk to our view, particularly as the next phase of Brexit negotiations on transitional arrangements will begin soon."

The TD Securities team bet on the Pound-to-Euro rate comes in the wake of a successful bet in the UK interest rate market. They had used interest rate derivatives to bet that markets would soon begin to price a higher Bank rate for the month of May.

The implied Bank rate for May, at the time when they entered the trade, was just 0.47% but by the London close Thursday, the implied Bank rate had risen above 0.70%.

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Elsewhere, analysts at Danske Bank have announced an upgrade to their Sterling forecasts in the wake of recent events.

"Based on the hawkish signal from the BoE, we now expect the bank to hike the Bank Rate to 0.75% as early as May (previously February 2019). As this seems like the beginning of a hiking cycle, the BoE is likely to hike again in November," says Mikael Olai Milhøj, Senior analyst with Danske Bank.

Markets are now pricing a ~70% chance of a May interest rate rise having priced a ~50% chance heading into the BoE event.

Milhøj does take a slightly different stance saying in the short term his team see little room for higher rates "but believe the curve will steepen substantially further out" which implies a number of interest rate rises in latter months.

"This has strengthened the case for a lower EUR/GBP," says Milhøj.

Danske now expect EUR/GBP at 0.87 in 3M (previously 0.88), 0.86 in 6M (0.87) and 0.84 in 12M (0.86).

"Brexit remains a key driver for GBP, but the currency is likely to be more sensitive to UK data," says Milhøj.

A Euro-to-Pound exchange rate at 0.87 gives us a Pound-to-Euro exchange rate at 1.15, 0.86 gives us 1.16 and 0.84 gives us 1.19.

Not everyone is backing Sterling however and there remains a sizeable contingent of Sterling bears.

“The failure to break EUR/GBP 0.87 while I was in the Far East has convinced me that the next move is to 0.92 and beyond. GBP is already very cheap,” says Kit Juckes, chief FX strategist at Société Générale.

Translated into Pound-to-Euro terms, Juckes says that given Sterling failed to break sustainably above the 1.1500 level against the Euro in January, a reversal and subsequent return to 2017 lows around the 1.0870 level is now likely.

“EUR/GBP (which correlates very well with the GBP Trade Weighted Index, unlike GBP/USD), has averaged 0.75 since the birth of the euro and has only traded above 0.90 on 3% of the (4985) days since then, but even so, it's worth a trade,” Juckes adds.

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Pound Sterling went from hero to zero in the space of 24 hours with the currency shedding the gains realised in the wake of the Bank of England policy meeting on the back of a ratcheting up of Brexit tensions. Sterling fell during a press briefing on Brexit negotiations conducted by the European Union's Michel Barnier in which the tone was judged by markets to be negative.

Any hope that we would move away knee-jerk market reactions to Barnier's every breath - as was the case during 2017 - appears to be misplaced.

Barnier told assembled journalists in Brussels that a transitional Brexit period "is not a given".

"Appears Mr Barnier is voicing concerns over the Brexit transition & the Irish border. The Pound is pushing lower as the pendulum shifts from a soft to a hard brexit. Some suggest a soft Brexit is indeed dead, leaving a hard or a very hard option. The Pound should continue to trade lower on the crosses," says Neil Jones, an analyst with Mizuho Bank Ltd.

Barnier cited the Irish border as an issue once more with the EU gunning for full alignment in EU regulations between Northern Ireland and Ireland.

In short, Northern Ireland is expected to remain in the single-market, which in turn creates a border within the UK; you can be assured the UK government nor the Northern Irealnd's largest party the DUP will not accept the splitting of the UK.

It appears those issues which were apparently agreed upon in late 2017 were perhaps not agreed upon at all.

The worst possible scenario for the British Pound pertaining to Brexit is that whereby the EU and UK separate abruptly in the event of no transitional deal being agreed. If no transitional deal can be agreed, you can bet your bottom penny that no trade deal will be agreed which opens the door to the trading relationship between the two jurisdictions defaulting to WTO rules.

Indeed, it is the chaos that an abrupt Brexit presents that is most disconcerting to businesses, and by extension the UK currency which was the second-worst major currency of the week.

At the weekend, the Pound-to-Dollar exchange rate is at 1.3830 having opened Friday at 1.3935, the Pound-to-Euro exchange rate is at 1.1290, having opened at 1.1364.

“The losses against the Euro are even more pronounced. With Brexit once again moving back onto the markets’ radar, risk of a sterling downturn has returned and even the Bank of England’s aggressive policy outlook hasn’t provided much support to the pound. It will be interesting to see how the markets respond to the EU summit towards the end of the month, and any news that leaks from it,” says Hamish Muress at brokers OFX.

Sterling bulls will nevertheless be feeling particularly hard done by considering how well the Thursday, February 8 Bank of England went. Note though that at the time BoE Governor Mark Carney did say the next interest rate rise at the Bank of England was contingent on progress being made in Brexit negotiations.

So markets might feel justified in dropping the Carney 'put' for the Barnier 'call'.

Pound Sterling was one of the best performing G10 currencies in 2017 as it successfully "climbed a wall of worries" concerning the U.K. economy's ability to withstand concerns surrounding Brexit.

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